Riding the hype: Why gut investments can lead to losses
Investing in exciting and promising prospects, such as all-healing biotech or artificial intelligence and robotics companies, where investors look for stocks with interesting stories, is all the rage right now. In the long run, however, this is not always a good strategy, as most of these stocks do not generate sustainable profits and eventually disappear into oblivion. Even the biggest companies in the fast-moving technology sector often disappear. It is an emotional challenge to resist the pull of good stories, but historical experience shows that it is more rational to avoid such stocks.
A lower number of shares outstanding is usually good for returns. Companies with a declining number of shares have outperformed the market by about 3% per year over the past 100 years. In contrast, companies with an increasing number of shares have underperformed the market. These correlations are consistent across market phases and industries. Companies that continually raise capital tend to be poor investments because they often have no or negative cash flow and are constantly dependent on the capital market.
Issuing employee options dilutes shares and hurts shareholders. Many companies simply exclude the cost of options to improve profitability. However, this increases the number of shares outstanding and dilutes shareholder ownership. Buying back shares on credit can also be problematic because higher interest rates can hurt earnings per share. Companies should fund share repurchases out of free cash flow rather than by increasing debt. Share buybacks are particularly useful in value investing, where undervalued shares are purchased. Buybacks increase ownership and future earnings without requiring shareholders to put up additional capital. This leads to an increase in earnings per share, especially when profits are rising.
It is therefore worth monitoring the share count and avoiding companies that cannot finance themselves or have large employee option programs.
A lower number of shares outstanding is usually good for returns. Companies with a declining number of shares have outperformed the market by about 3% per year over the past 100 years. In contrast, companies with an increasing number of shares have underperformed the market. These correlations are consistent across market phases and industries. Companies that continually raise capital tend to be poor investments because they often have no or negative cash flow and are constantly dependent on the capital market.
Issuing employee options dilutes shares and hurts shareholders. Many companies simply exclude the cost of options to improve profitability. However, this increases the number of shares outstanding and dilutes shareholder ownership. Buying back shares on credit can also be problematic because higher interest rates can hurt earnings per share. Companies should fund share repurchases out of free cash flow rather than by increasing debt. Share buybacks are particularly useful in value investing, where undervalued shares are purchased. Buybacks increase ownership and future earnings without requiring shareholders to put up additional capital. This leads to an increase in earnings per share, especially when profits are rising.
It is therefore worth monitoring the share count and avoiding companies that cannot finance themselves or have large employee option programs.